THE OAKMARK EQUITY AND INCOME FUND Report from Clyde S. McGregor and Edward A. Studzinski, Portfolio Managers

THE VALUE OF A $10,000 INVESTMENT IN THE OAKMARK EQUITY AND INCOME FUND FROM ITS INCEPTION (11/1/95) TO PRESENT (6/30/05) AS COMPARED TO THE LIPPER BALANCED FUND INDEX10
	Average Annual Total Returns
	(as of 6/30/05)
	Total Return Last 3 Months*	1-year	5-year	Since Inception (11/1/95)
Oakmark Equity & Income Fund (Class I)	2.83%	6.24%	13.03%	13.78%
Lipper Balanced Fund Index	1.79%	7.12%	2.70%	7.85%
S&P 5005	1.37%	6.32%	-2.37%	9.46%
Lehman Govt./Corp. Bond11	3.44%	7.26%	7.70%	6.77%
The graph and table do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.
The performance data quoted represents past performance. The above performance information for the Fund does not reflect the imposition of a 2% redemption fee on shares held for 90 days or less to deter market timers. If reflected, the fee would reduce the performance quoted. Past performance does not guarantee future results. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Average annual total return measures annualized change, while total return measures aggregate change. To obtain current month end performance data, call 1-800-OAKMARK or visit www.oakmark.com.
* Not annualized

"Stand upright, speak thy thoughts, declare the truth thou hast, that all may share; be bold, proclaim it everywhere: They only live who dare." Voltaire

Our Results

The Oakmark Equity and Income Fund increased 3% for the quarter ended June 30, bringing the calendar year gain to 2%. For the calendar year 2005, the Fund has outperformed the Lipper Balanced Fund Index, which has returned 1% for the year. As this represents another period of absolute positive returns, we are moderately pleased with this result. As we have said many times, it is absolute positive returns that preserve and grow your capital. Looking back over the past three-year and five-year periods, we have grown and compounded the capital of our long-term investors (ourselves included) at a 10% and 13% rate annualized respectively. We continue to dedicate ourselves to keeping those returns consistent and remain vigilant against any sloth or complacency. We are particularly mindful of something Mark Twain once said, "All you need in this life is ignorance and confidence, and then success is rare." As you may recall, we started 2005 again feeling cautiously pessimistic, without any great convictions, and the year has continued to play out that way, albeit with markets around the world showing a tremendous amount of volatility.

Oil, Oil, Everywhere!

Two factors primarily contribute to that volatility: the strength of the U.S. dollar and the continued increase in energy prices. We have been somewhat perplexed by the former, but we are willing to chalk it up to concern about the Euro and the European Union, given the rejection by the voters of France and the Netherlands of the draft EU Constitution. With regard to energy prices, we find the increases understandable given the tightening of energy's supply and demand dynamics. As we have previously discussed, increased demand makes sense to the extent one accepts that developing market countries, such as China and India, continue to demand substantially more oil than generally forecast. Indeed, both of those countries have moved aggressively to secure increased supplies of petroleum to support their economies' expanding needs. (In the case of China a snowball effect may develop because the Chinese are also seeking to lessen their dependence on coal, with its not-so-hidden environmental costs, and shift consumption to cleaner forms of energy such as oil, natural gas, or liquified natural gas.) The most recent evidence of this aggressiveness is to be found in the bid by a Chinese oil company, CNOOC Ltd., for Union Oil of California.

In terms of energy supply, we agree with those who say that there is plenty of oil left out there; Saudi Arabia is supposed to be capable of doubling its current production of about 10 million barrels per day. The issue that is now coming to the forefront is the ability to get oil out of the ground (production rates), due to a number of artificial constraints that impede companies' ability to get petroleum products refined and to the markets.

A half-century ago, M. King Hubbert, a Shell Oil geologist, argued that production rates for oil and natural gas basically follow a bell curve: production rates from new fields rise steadily until the peak (top of the curve) is hit, at which point—with roughly half of the oil or gas in place produced—production rates decline. Therefore, Hubbert predicted that production rates in the U.S. would peak around 1970 and then begin to slide downwards. While new technologies have slowed the rate of decline, Hub-bert's predictions were fairly accurate. Applying similar logic, many people are now raising the possibility that the world's production has already peaked, claiming that existing fields face an inexorable decline, which might be slowed but cannot be stopped. The offset of this production decline was supposed to come from Saudi Arabia, with both shut-in discovered production and large tracts of unexplored areas that could hold future gigantic fields. Two somewhat recent books question the promise in Saudi Arabia. The End of Oil¹² by Paul Roberts argues that in their attempts to enhance production by injecting water in the Ghawar field—Saudi Arabia's largest oil field—the Saudis unwittingly contaminated that field. The second book, Twilight in the Desert¹³ by Matthew Simmons, argues that most Saudi production comes from only seven or eight oil fields, all old and all in decline, and again, their best days have passed. He further argues that the Saudis are already using the best recovery technology that money can buy, so not much more can be squeezed out of their fields.

We think that these are interesting arguments, especially given the lack of transparency that surrounds so much of the energy world. That said, our energy investments are focused on companies that have access to natural gas in North America. We believe that natural gas in North America has compelling and more easily supportable supply-demand dynamics than oil. North America is experiencing a dearth of new natural gas discoveries, a lack of new pipelines, and a "not in my backyard" approach to liquified natural gas terminals. The natural gas supply chain in the United States has basically no margin of safety left in it.

Oakmark's investment philosophy has always been to buy companies that are selling at a discount to the underlying values of their assets. In the case of the energy sector, our asset value analysis is centered on the value of oil and gas reserves. In addition to a discounted price, we also require that companies are run by managements that think about their businesses the way we do. That is, they are responsible for a pool of assets. They should recognize—and act—when the right price is reached for purchasing additional assets and when the right price is reached for disposing of their assets. At all times, they should act according to what is best for their shareholders. Our investment process explicitly seeks to avoid companies—in any sector—that don't meet these criteria. Within the energy sector, in particular, this helps prevent us from investing in those companies that are run by managements with an irrational love of the energy business for its own sake. Our disciplined process has resulted in a short list of what we believe are very attractive energy stocks. If our assumptions about supply and demand dynamics prove correct as well, we could also capture the upside in the commodity's price for free.

Change at the Margin

In keeping with our belief that sometimes the best thing we can do is nothing, there were not a lot of transactions in the portfolio from a dollar-volume perspective during the quarter. Abbott Laboratories, Darden Restaurants, and Office Depot were eliminated from the portfolio because they reached valuation targets. New positions were initiated in Morgan Stanley, Pulte Homes, Sanderson Farms, and Tree House Foods. Our low turnover indicates that many of our portfolio holdings remain comfortably away from their valuation targets. However, those investments that are creeping close to their valuation targets have allowed us to ease incrementally out of them while we ease incrementally into new positions. We continue to see no abundance of compelling ideas, although a few interesting opportunities arose (but at prices with lesser margins of safety than would interest us). That said, we are comfortable with our holdings, and we continue to believe that we will have the opportunity to deploy capital into one or two truly outstanding investment ideas over a twelve-to-eighteen month period.

Summertime, when the Reading Is?

We would like to commend to you a favorite, although not newly published, book titled Fooled by Randomness - The Hidden Role of Chance in the Markets and Life¹⁴ by Nassim Taleb. Although not a page-turner, the book is useful for those trying to understand the statistics of the market, especially figures relating to performance. Taleb also puts into context some of the behaviors that can result in subpar investment performance. For example, if you can place a $1 bet that has 999 chances in a 1000 to make $1, and 1 chance in a 1000 to lose $10,000, you arrive at an expected return of a loss of $9, arrived at by multiplying the probabilities by the related outcomes and then summing. Many young analysts and portfolio managers often get fixated on the fact they would probably make money because the frequency of winning is so great. Wrong. The probability of loss is not what you should be concerned with. The magnitude of the negative outcome, which swamps everything else, makes this a bad situation to bet on. Put another way, investment opportunities do not always involve a normal distribution along a curve. Taleb's point is one with which we wholeheartedly agree and which, interestingly, a frequenter of the racetrack understands intuitively. Yet many people with fancy degrees and titles, who are responsible for other people's money, often do not.

Curmudgeons

We are often thought of as the curmudgeons of this investment firm, but it does not bother us that we may be an endangered species. Another famous curmudgeon, George Santayana, once said that "Advertising is the modern substitute for argument; its function is to make the worse appear the better." Our purpose, we assure you, is not to advertise but to inform you—our investors, partners, and readers—as we should like to be informed ourselves. Our goal continues to be to make an absolute positive return for you (and ourselves) as shareholders. That goal has not changed and will not change. We continue to not do anything different than what we have done in the past—searching for business values in the market place priced at a discount to intrinsic value, with a margin of safety that we like. We remain grateful to you, our shareholders and partners, for your patience and confidence in entrusting us with your capital to manage.

Clyde S. McGregor, CFA Portfolio Manager mcgregor@oakmark.com	Edward A. Studzinski, CFA Portfolio Manager estudzinski@oakmark.com

Schedule of Investments—June 30, 2005 (Unaudited)